Credit building is a crucial activity in laying the foundation of your financial future. While credit cards may be helpful, they may not be affordable. In such a case, taking out a small personal loan help in building your credit? Find out in this article ⭐Personal Finance ⭐Money Management ⭐Credit Score ⭐Personal Loan
Credit plays an important role in the financial aspect of our lives. Your financial planning and decision making have a significant impact on your credit rating. A good or a bad credit score will be a reflection of how good or bad your financial history has been. If you’re planning on building or rebuilding your credit, one way to do it is by taking on some debt and repaying it in full, within the loan term.
You may choose a credit card as a form of debt. However, credit cards often come with sky-high rates of interest.
In such cases, taking out a small personal loan may turn out to be a better idea. Several lenders lend money with credit situations like these. However, you may not be able to avail of better options with lower interest and APR.
Here’s everything you need, to get a better understanding of using a personal loan to build credit and boosting your credit profile.
Factors affecting your credit score
Taking out a personal loan will have both – good and bad influence on your credit score. While taking a loan will temporarily reduce your credit score as you acquire new debt, but this damage will be undone once you clear the loan without any defaults. This exercise can help you strengthen your credit profile over time.
To understand the impact of a personal loan on your credit profile, it is important to learn how the score is calculated. Experian, Equifax, and TransUnion are the three major Credit Rating Agencies (CRAs) in the UK. On a holistic level, payment history, existing debt, length of your credit history, and the number of credit lines are some factors taken into account while determining the score.
Below is a breakdown of approximately how much each factor contributes to your overall credit score:
- Your payment history constitutes about 35% of the score
- 30% is based on the total amount of your outstanding debt
- The length of your credit history takes up 15% of the score
- 10% is based on any new loan/credit that you’ve acquired
- 10% is based on credit mix—the number of credit lines that you have open (including credit cards)
How will a personal loan influence your score?
Taking out a personal loan will help you build credit by helping you with the 5 factors that control your credit score:
- Payment History: A key factor through which CRAs assess your creditworthiness, is your repayment history. So taking out a loan and timely repaying monthly installments in full will aid in demonstrating responsible credit behavior.
- Credit Utilization: Your credit usage is based on how well you handle your money. How much money you owe to a lender or a creditor, and the kind of debt you are in, also impacts your usage. Taking out a personal loan and repaying it on time can help improve your credit usage, as long as you don’t pile on other debt.
- Length of your credit history: Your credit history can be a good tool to establish responsible credit management over some time. So if you want to build your credit profile from scratch, taking a personal loan is a good place to start. As you keep paying your installments on time until you’re debt-free, you may see a gradual improvement in your credit history.
- Credit mix and types of credit: Credit mix comprises multiple types of debt such as credit card, loans, and mortgage. If you don’t have a substantial credit history on your profile, a credit mix of loans and credit cards or mortgages can give you a good kick-start.
- Outstanding credit: If you apply for a new loan despite having outstanding debt, your chances of approval may diminish. Even if you manage to get one, the repayments for both may overwhelm you. Moreover, defaulting on outstanding debt and taking on a new one will do more harm than good to your credit score. Therefore, build your credit by tackling one debt at a time, without defaulting in repayments.
Consider this before opting for a Personal Loan
Now that you know better and choose to opt for a personal loan, the next part is understanding the outcome. Below are some Dos and Don’ts to ensure that you aid rather than damage your credit score with a personal loan:
- Do Rate shopping – When you want to take out a loan, the first and foremost step is to shop around for the best offers. You may be tempted to accept the first offer you get, but consider the interest rate and APR being offered by this lender. Some loan offers may seem appealing, but there’s no harm in checking what other lenders have to offer. As they say, a penny saved is a penny earned.
Compare Personal Loans with Real Interest Rates
- Don’t apply for too many loans – When you apply for a loan with multiple lenders, they will all check your credit history. All hard credit checks on your profile appear on your credit report. Too many hard checks can damage your credit score. While this damage is repairable, lenders tend to put most of their focus on credit scores. So it may take a while before you can apply for a loan again.
- Do read the terms and obligations of the agreement carefully – Once you apply and get an approval on your loan, next comes the paperwork. It is imperative that you thoroughly scrutinize your loan agreement and discuss any issues beforehand. Take some time to understand any terms or definitions in your agreement that you’re unfamiliar with. Look for any penalty clauses on early repayment or anything that could otherwise cause your interest rate to increase.
- Don’t borrow more than what you need – If your sole purpose to take a personal loan is to build credit, you might as well borrow a small amount. Even if you get approved for bigger loan amounts, it is wiser to build credit using smaller loans. This will allow you to build your credit, without overwhelming you with a huge debt.
- Do check if your lender reports your payment history to CRAs – You push yourself to maintain a good payment history by making timely repayments. Imagine that your lender isn’t reporting anything to the three major CRAs. That’s right. It is important to keep an eye out for such discrepancies and discuss them with your lender. If you’re not attentive, you may end up months paying on time, only to find that none of that was helping in improving your score.
- Don’t default with repayments – If you are taking a personal loan to build credit, you cannot be negligent with repayments. If you miss a payment for 30 days or more, your lender will report this default to the CRA. This will further damage your score, defeating the purpose of taking a personal loan in the first place. Any delinquency in terms of repayment will make this exercise a futile attempt to improve or build credit. So ensure timely repayments towards your loan every month.
Credit scores play a key role in your finances. However, not having one doesn’t make you financially untrustworthy. It’s never too late to start building your credit. If used right, and practically, a personal loan can come in handy in helping you establish your credit. You can choose from a variety of options to build credit, but it all boils down to be careful while choosing a loan offer.
Loan shopping gives you a chance to choose the best one from a range of offers. Visit LoanTube to compare loans from multiple lenders based on Real Interest Rates. That’s not all. You can also check your acceptance rate for loans, with just a single application form.
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